The Dividend Cafe - Quantifying the Quantitative, or Making Easy the Easing

Episode Date: July 16, 2021

Like most of you, before the financial crisis, I had never heard the term or uttered the term “quantitative easing.” This somehow becomes completely standard fare in the lexicon of finance in the last 13 years, and it is now uttered by people who I am 1,000% positive do not know what it is dozens of times per day in the media. There is nothing wrong with not understanding the obscure vocabulary of monetary economics unless of course, you are sitting around using the obscure vocabulary of monetary economics. But words have meaning, and today we’ll look at some of these words. But we will do more than define words today. After all, you deserve to get your money’s worth for what you pay for this Dividend Cafe subscription! My goal today is to walk you through the history of quantitative easing, explain what policy goal it is serving, what policy goals it is not serving, and what it means to you as an investor. By the time you are done with this read, I believe you will be a QE expert. And I assure you, as a fellow QE expert, nothing makes you more popular at parties than knowing the deep dive of quantitative easing! It’s a good thing I’m married … Okay, QE and why you should care, in this week’s Dividend Cafe! DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to another week of the Dividend Cafe podcast. And those of you watching on video, I am sitting in the New York office studio and pretty excited to talk to you about today's topic, which is quantitative easing. And just before we began this recording, I was talking to my wife on the phone and I told her what I wrote Divin Cafe about this morning. And it was really clear in her voice that she was pretty excited about it. And I expect that you guys are going to be equally excited. The sarcasm is based on the fact that quantitative easing may

be one of the most boring subjects known to mankind for regular people who have lives. I'm not a regular person and I don't have much of a life outside of all this. But the reality is that quantitative easing in financial media right now may give one the impression it's the only thing that's happened in the whole entire economy. QE, as it is called for shorthand, is a big topic in monetary economics. It's a big topic in investment finance. And there's a reason why I want to address this topic. And there is a sort of once and for all kind of vibe going on here. I want to cover this today in a way that we'll cover it once and for all, because the media will keep the topic going. The topic does have real currency in actual Fed activity and in a policy framework into the future.

It's kind of embedded into this part of national economic planning since the financial crisis. And yet I want the once and for all to be how we think about it as investors, and in my case, as investment managers at the Bonson Group. So I'm going to try to explain it a little, unpack it, and then give you kind of my own commentary, both from a policy standpoint. If I could be not king for a day, but Fed governor for a day. What's the difference between king and Fed governor? Fed chairman is far more powerful than the king. But no, it's not just if I were Fed chair for a day, it's also the non-hypothetical of me actually being the chief investment officer at the Bonson Group, how I think about this topic and want you to think about this as investors who live your lives with goals and therefore have the capital markets as a tool at your disposal to help meet and satisfy goals,

which is very different than the way a lot of people have to approach the subject of quantitative easing. So there's some data here that's in the written dividendcafe.com that I'm going to hold on to because I want to cite it accurately as we go through it. But let's just start with some history, okay? We had never really used the term quantitative easing ever. And I'm saying from the Vance point of being an investment professional prior to the GFC. At the point of the great financial crisis, we were introduced to not just the terminology, but in our country, we were introduced to the policy itself. And it was the notion of using the central bank as a buyer of bonds as a policy tool to affect interest rate policy and affect liquidity in financial markets.

It was meant to be a stimulative tool to help the Fed achieve its dual mandate of price stability and full employment. Clearly, they would have been targeting more of the full employment side in their thinking, in their framework by the use of quantitative easing. What it actually is, which A, I'm about to explain, and B, was remarkably explained with quite a bit of candor and frankly, pretty impressive clarity by one Ben Bernanke himself. himself and gosh I usually remember dates vividly I want to say that it was in late 2009 um at what at what point Ben Bernanke did a pretty famous 60 minutes appearance and he was in his hometown of uh south in South Carolina um where he was interviewed by 60 Minutes on that lengthy episode, which had a whole lot of things that were going on.

I remember distinctly him giving the American people a sort of definition of quantitative easing. I thought he did a really good job. But what it is is the Fed buying bonds from banks, the major dealer banks that are the authorized dealers of United States Treasuries. The Treasury goes and issues these bonds at auctions. Our dealer banks buy the Treasury bonds. That's how our government spending is financed. They sell bonds, they receive cash, and then they go spend the money. So that's what the government does. They issue bonds, banks buy them, those banks then go

off to sell them or hold them on their balance sheet or whatever they're going to do. The banks with quantitative easing are then selling these bonds to the Federal Reserve. The Federal Reserve is paying them cash for the portion of the bonds that they're buying. A lot more bonds get issued than what the Fed's buying. But my point is, the portion the Fed's buying through quantitative easing, they are crediting the banks with cash, and that cash goes to the bank's excess reserves above and beyond the statutory reserve requirements that they have to have to function as a bank. That sits as cash at the banks, and then the Fed receives the bonds. Now the Fed is holding a bond, which is an asset on the Federal Reserve's balance sheet,

and the government has the liability, which is they have to pay that bond back at the maturity date. You follow me? So the Fed began doing that. Now what is the stimulative part of it here? Well, the Fed is buying these bonds with money that they don't have. The Fed is buying these bonds with money that they don't have. They're just simply doing it as a computer entry, which was the way Bernanke explained it on 60 Minutes 12 or 13 years ago. And he said it's effectively like printing money. Now, I've pointed out we think of printing money as them rolling a copy machine of money that's spitting out, and then it's been kind of dispersed out into the society.

And even Bernanke himself talked about helicopter money, which is, I think, the way people view quantitative easing, that they're dropping money out of a helicopter that people could pick up out of a village, you know, go spend it in a town or whatnot. With quantitative easing, they are putting this money in the reserves of balance sheets, excuse me, the reserves of bank balance sheets. And then that money has to get circulated in the economy. And that's the whole velocity conversation and loan demand conversation I've talked about so many times. That's the difference between money printing

and quantitative easing. Now, the issue that is making me address this today is not for another kind of side chapter or sort of wing to the inflation deflation discussion. Rather, I want to talk about this because of the way in which it will impact market activity over the months and quarters ahead. And by the way, when I say market activity, I do not mean stock market activity alone. I mean stock and bond market activity, full financial market activity. And one could argue that the priority might even be stronger out of the bond side than the equity side. But what I've done at Dividend Cafe this week is try to provide a little historical context. Let me give you a couple of numbers to chew on here. Before the Fed

first began quantitative easing as an emergency measure at the time of the financial crisis to try to breathe a little life and a little extra stimulus into what was a really beaten and bruised patient, the American economy dealing with the recessionary and contractionary and deflationary pain of the great financial crisis. And this is classic spiral stuff. You have economic weakness, banks then can't lend, and therefore you get more economic weakness. This is the classic debt deflationary trap. And so what the Fed was trying to do is provide every possible resource they could to generate more borrowing activity in the economy.

And as I've pointed out in recent writings, where they were very successful was reflating the American economy in the corporate sector. Now, we know that the government took on a lot more debt, but really, as households were necessarily de-levering, they used policy tools to try to successfully get reflation out of the corporate economy where it could be most productive. And I think it was. And I think that that part has reasonably worked up until this point. And yet, what was presented as an emergency policy tool very quickly became not an emergency. It lasted in a number of different cycles. So I want to talk about the yield curve here and how it's responded to quantitative easing. cycles. So I want to talk about the yield curve here and how it's responded to quantitative easing.

You had before quantitative easing one, QE1 began, a 2% spread between the two-year treasury and the 10-year treasury. All right. The investor was going to receive 2% less to own 2% bonds and 10, two year bonds than they would with 10 year bonds. And that spread widened up to 2.8% by the time that QE one was done. And a few months after it ended, it had come back down to 2.3%. So it widened in, in response to QE actually happening, and then the spread tightened a bit afterwards. Now, QE1 was relatively small. And I make a point of saying, for those who believe that the equity markets went up in direct response to QE, it is true,

they began QE1 in March of 2009, and they stopped it in March of 2010. And in that period of time, the markets were up 40%. But you had a lot of factors going on. Early March was a generational bottom in the stock market. And creating a cause and effect or a causation out of a correlation is very difficult to do. You could argue that part of the reason stocks went up so much was because they were way too oversold, that earnings capacity for those companies had been overdone to the downside.

You could argue that FASB 157 was a big part of it. The mark-to-market accounting rules that they repealed, allowing banks to kind of remark things and that enabled a lot of breadth of new life in financial markets. You could argue that the TALF facility was a huge part of why markets began to recover, which was the Fed creating a special purpose vehicle to buy a lot of the asset-backed residential commercial mortgages, levered loans, car loans, credit cards, student loans. They start buying these esoteric assets out of a facility they created that kind of

unclogged a lot of credit markets. I am in the all of the above camp here. I think that equities began recovering because of all these things. And I think QE1 was part of it but i'm focusing right now on the yield curve you can then get the qe2 at the end of uh august 2000 and let me see my 10 excuse me so we went from march of 010 all the way till um the end of the summer with no QE. They had stopped QE. We didn't call it QE1 then, but just QE was done. And then in Jackson Hole, Wyoming, and I will never forget this the rest of my life, the Fed announced that they were looking at perhaps another round of bond purchases of QE2.

That was in late August of 2010. And they didn't end up doing it until about December, but the market immediately began pricing and the reality that this was going to happen. So at this point, you had a 1.9% spread now between the two-year and the 10-year. And they start talking about it and they start buying in December and the spread blows out to 2.7. Nothing obnoxiously high there, pretty healthy. But then by the time that they were done, the spread had come all the way back down to 1.7. So the same directional moves, QE1, QE2, and then QE3, which was the real big one, that's when they just went And then QE3, which was the real big one, that's when they just went bazooka with bond purchases.

It lasted a very long time. That 210 spread was only at about 150 basis points, 1.5%. And they went on to a couple years of bond buying, and the spread got all the way to 2.6%. And then by the time they were done and they announced and they tapered off, spread had come back down to 1.8. So three out of three times, you had a reasonably tight spread. They do QE, you get a wider spread. They announce QE is ending, you get a tighter spread. And I think that is what the bond market does, is it's responding, it's expectations. market does is it's responding, it's expectations. It's not responding to the news. It's responding to what they see going forward. Okay. And so what you've had here with COVID, which is a bit unique because the yield curve was so tight back in February, March, 2020, it was basically dead flat. And they widened the curve. It got all the way to 180.

I want to get this exactly right. 158 basis points was the widest we got back in March. So it was a full year later. They've been doing QE infinity. And all they were able to get was 158 basis points between the two-year and 10-year. But that was coming off of it being totally flat. So again, did QE do that? Or did the fact that the economy reopened and that COVID didn't kill everybody and all the things that we were worried about a year and a half ago, as that economic improvement came, the spread kind of pushed out. Now, as you start hearing

talk about talk about tapering, and not just even the Fed signaling it, but just the common sense of the fact that we know it has to be coming, the $40 billion a month of mortgage bonds being bought when housing is utterly on fire. As the market starts to prep for it, you've seen the spread tighten a bit. And as I'm talking here right now, I looked just a few minutes ago, the two-year is at 0.24%, the 10-year is at 1.3%. So you got a little over 1% of spread. So we were at 1.58%, now we're back to one. So now make it four out of four times that you had a tight spread. Now it's QE. You get a wider spread. Right at the end of the tunnel, you get a tighter spread. And I think that what this means is that expectations get priced into

the bond market and probably get priced in the bond market even better than they do in the stock market. It's a larger marketplace. It is a highly efficient one around bond yields and so forth. Well, I think it's incumbent upon me to explain what in the world this has to do with you, why this matters. You know, Federal Reserve Chairman Jay Powell is up for renewal. OK, the president has this authority to make his nomination. And if he were to not re-nominate Jerome Powell, I think it would be one of the very first things people would want to ask the successor nominee. What are your plans with quantitative easing? I find it very

hard to believe that Jerome Powell will do much of anything very aggressive before some settlement about that. And that's partially why I expect the president will likely announce his intentions much before the kind of renewal date. I think that he'll get in front of this because of its potential for disruption or enhanced volatility in markets. But the reality is that with the expectation coming, the yield curve tightening in advance of this, some form of tapering, of slowdown, of quantitative easing.

I made a list in Dividend Cafe today of eight different variables. Once you accept the premise that some form of slowdown of QE is coming, when will the mortgage bonds begin to be reined in? At what speed will the mortgage bonds be reined in? But then when will the treasury tapering be considered? Will they actually slow down on the treasury purchases? Because I'm assuming, of course, that the treasury purchases being tapered or slowed down will happen after the mortgage side. Theoretically, I could be wrong about that, but I don't think I am. But even that's another variable, another uncertainty. Once treasury tapering, a slowdown

of bond purchases is considered, when will it actually take place? Because I think there will again be a lag. Bernanke's so famous taper tantrum in the markets. I remember it like it was yesterday, it was June of 2013. And then in October of 13, he announced that they were going to start doing it in December of 13 to go all the way till October of 14. So it was a June of 13 kind of flirt that didn't actually end all the way until October of 2014. So I expect to see some more of that, which again, adds to kind of uncertainty and questioning around timeline of all these things. Once it's announced, how long will the tapering last? What will the rate impact be as QE is slowed? What will the government spending be as QE is slowed? And will the market fund the deficits that that spending creates when the Fed is not buying the bonds from banks? And will an

emergency happen economically along the way before the QE has come to an end that requires the QE to be reaccelerated? Now, I'm sure there's more things that could belong to this list, but my point is here's eight or nine things that are all variables that are of no interest to me whatsoever when it comes to the long-term asset allocation of a well-constructed portfolio, but all of which represent different opportunities for hedge funds, for traders, for day traders, for algorithms, for high frequency, for various short-term market actors that don't have the financial goals you have to have a point of view, to want to express a position in the form of a trade. And that is necessarily volatility enhancing.

So I don't think it's just going to be a key matter of hand-wringing at the Fed how they're going to handle all this with the political ramifications of that around Powell's reappointment. I don't think it's going to just be a media focus, something that the press is talking about incessantly. I think it's going to be a lot of opportunity for additive volatility in markets that you could argue are already a tad volatile. this is the necessary reality of emergency measures that when the emergency ends it's very hard for the measure to end and this is true of fiscal stimulus of government spending of government programs it's true of low interest rates and this is the predicament we're in now with quantitative easing.

Does quantitative easing have a legitimate function? I don't believe right now it does, but I understand the signal it represents to markets in the point of an emergency when there is financial market destabilization to try to communicate from the central bank a sort of bazooka approach. We stand on the ready to do whatever it will take. And I think it can help lubricate financial markets when things have tightened up a lot in credit. Ultimately, though, what I think it can't do, and this is a list I put in Diven Cafe this week I recommend you look at,

it cannot contribute to organic economic growth. The mere existence of more widgets that have accumulated in the corner of a room, in this case, excess bank reserves, it cannot lead to more goods and services and innovation and human action that actually drive economic activity. It cannot lead to increased bank lending. It can lead to more reserves that are sitting there at the banks, but it can't make the bens or motivate the banks to lend. And it cannot lead to more consumer or corporate borrowing. And in fact, I think the inclusion of mortgage-backed securities certainly can't be said to help be needed to help the housing market as we now get to brand new levels of unaffordability in the housing market. The

percentage of house payment divided by income for median home price right now is back to pre-crisis levels. It's just really extraordinary. And the idea that the Fed would need to be supporting that, if anything, you would think they want to support it the other way, like bring these prices down. I think that then the fifth side of the kind of negatives of QE is that it has helped to sort of distort markets by leaving this lingering uncertainty that has to be resolved. So maybe it has a policy function, but that reaction function gets diminished over time. And it leaves market actors saying, hey, I want to do something, yet I know that there's this QE thing out there, and it might come off, or it leads to an uncertainty, it leads to a risk. And this is getting to the conclusion of my treatment on QE, and I think it's a contrarian

view. Equities are always and forever priced as a discounted reflection of their future earnings. based as a discounted reflection of their future earnings. That's what equities are worth. That's why we buy stocks as a discounted current total of future earnings capacity. Stocks are going to trade to that value at some point or another. And there's a lot of noise and a lot of sentiment around it that can distort it. But that mean reversion is a real thing. What I think creates more volatility in markets than anything else is not bad news, it's uncertain news. And QE is becoming a narrowly uncertain proposition into markets. So therefore, one has a choice to make between focusing on the uncertainty and the volatility and the noise of all these variables around QE settlement, or to focus on the uncertainty and the volatility and the noise of all these

variables around QE settlement or to focus on the earnings capacity of companies. One forces you to have to hit the mute button and have a longer term approach. One forces you to make a ton of mistakes along the way because you will not get this right around all of that variability in the aftermath of QE. My contrarian view is that coming off of quantitative easing will be healthy for markets. That's different than me saying it will not create all this volatility. I'm very much forecasting a lot of short-term vol from these aforementioned players, traders, hedges, algos, in the immediate day-by-day, week-by-week, quarter-by-quarter kind of forecasting of what the Fed's going to do and when they're going to do it. But then on the other side of this is the removal of something that is

an impediment. And I just got done saying that uncertainty is tough for markets and once QE is removed you have removed an uncertainty and I think that will prove to be positive for markets so do we need to tolerate volatility that this process entails along the way I don't think it's avoidable but do I believe on the other side of it, we have markets that are incapable of organic economic profit-making without the effects of quantitative easing? I do not. And in fact, I believe quite the opposite. I think it removes an impediment, gives better price discovery,

and is less distortive. And by the way, reestablishes a policy tool for left-tail risk that may be necessary. You don't have a very effective access to emergency measures when you've already used them. And yet, if you restore the ability, you put this tool back in your toolbox next time we do have an emergency, then I think that's healthy for markets. So the chart of the week this week at Dividend Cafe is where I kind of sum up my view of economic opportunity. It is not in the market right now based on QE. It is not based on, oh, well, hopefully the Fed won't do

this or they'll slow down this. We'll keep the sugar high of this going longer. I see an American economy filled with assets, what we call non-residential fixed assets, plants, property, factories, equipment, machinery that is in desperate need of replenishment. There is a CapEx renaissance that could be happening. CapEx is tough to do if there's not enough capital. There's tons of capital. CapEx is tough to do if the cost of capital is too high. The cost of capital is very low. CapEx is tough to do if there isn't enough projects to go focused on.

There's not incentive. The companies have the ability to substantially increase their productivity by replacing assets that are outside their useful life. What keeps these companies from doing it? It has nothing to do with quantitative easing. There is a general economic trepidation around living above our means, the excessive indebtedness. This is the stagflationary, stagnation, disinflation, malaise, whatever you want to call it, the low-slow, no-growth dynamic I talk about so often. What we need is to focus and see a resurgence in organic, productive growth, and the opportunity set there comes from a CapEx renaissance.

I don't know if that will come or not, but I would rather be focused on that than focusing on what high-frequency traders are doing around quantitative easing. You're going to have to have the stomach for that over the next three months, six months, and 12 months, because we're now facing this again, where some sort of tapering or slowdown of QE is inevitable. It's necessary. It's needed. In my mind, it's healthy. And yet from yield curve activity to even equity market reaction, you expect it's going to increase volatility. And on the other side of it is the real reason that we invest in equities, the real reason that we can tie what we're doing in your portfolio to the achievement of your financial goals.

So thank you for bearing with this discussion on quantitative easing. I hope it has entertained you and thrilled you more than it would my wife. And with that said, thanks for listening to and watching the Dividend Cafe. Please spread the word, rate us, review us. With that, go enjoy your weekend. Thank you. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered

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